What did Secretary Paulson see in his crystal ball?

We can’t miss the drama on Wall Street.The president addresses the nation, newspapers’ headlines are all about the economy, McCain pauses his campaign to return to Washington, and there’s a ton of hype about this new bailout plan.What’s going on now?

The answer is that the government is attempting to find ways to steady the economy – and their best proposal seems to be a $700 billion bank-rescue mission.All this money would be used to by the bad assets from banks; in essence, all the risky investments in mortages that have now gone sour.“That would give companies cash to replace toxic debts,” The Wall Street Journal explains, “restoring capital, as well as the trust that enables banks to borrow and lend at reasonable terms.”

But $700 billion dollars is an unprecedented sum and an unprecedented amount of governmental involvement in the free markets.As President Bush said in his speech Wednesday night, under normal circumstances he would never favor this much money or intervention.But these are not normal circumstances.

Something prompted Secretary of the Treasury Henry Paulson to propose this action.Without this intervention, he forsaw something even more catastrophic.The question is, what did he see in that (hypothetical) crystal ball?

Let’s back up and examine again the collapse and governmental bailout of insurance titan AIG.

AIG has a huge presence that spans 130 countries.They are a complex financial institution that does many things, but one of which is selling a form of “insurance” to banks for investments.So if you were worried about how this banking crisis was going to affect your personal savings and accounts, you could go into your bank and they would probably tell you something like this: “It’s true we did have investments in the sub-prime mortages, and they did go bad.But your money is safe because we have insurance from AIG [or another company].We’re protected.”And what would happen if that protection went bankrupt?

This also ties in with the huge problem related to money market funds.Money market funds are low-risk investments that mainly offer security.This means that you may or may not actually make much money in the way of interest, but you’ve invested because you won’t lose your money in these traditionally safe investments.

Now, the problem is that many of these “safe” funds had investments in AIG that would be lost if the company went bankrupt.There was a very real possibility that all these funds would suddenly “break the buck”, so to speak, or have to report that the dollar you invested was now worth only $.97.This would trigger an enormous psychological problem, because it would effect nearly everyone, they would become panicked to learn that they no longer had as much money saved up as they thought they had, and this could cause a run on the banks, which was a feature of the Great Depression.

So the government bailed out AIG, deeming that it was too enmeshed in the economy to allow to go bankrupt, which raises huge problems of it’s own.

But not only was the economy still in trouble, the trust of the public was severely shaken.In the ten days following the bankruptcy of Lehman Brothers, the gigantic bank Washington Mutual collapsed mostly for that reason.In this short period, people frantically withdrew $16.7 billion, and created the classic “run on the bank” destruction.(WaMu was also taken over by the government and sold off today to J.P. Morgan, evidencing their rapid destruction).

And if the people don’t have trust, you have a psychological problem bigger than the economical problem.The public panics, withdraw their deposits, and banks shut down.Even though the Federal Deposit Insurance Co. has promised to insure private accounts up to a certain amount, the lack of faith in the economy still makes for a much bigger mess.

Secretary Paulson could see this spiraling out of control and having incredible effects on everyone.This vision is what prompted the $700 billion plan.Assuming the bill passes (which it may not), will it work?Will it stabilize the economy and the trust of the people?Is this the right step for the government to have taken? It’s a tall order, and one that may be impossible to fulfill.Time will tell…

Wow! Now I get it. These bad mortgages were like a virus that had multiplied and spread throughout banks, insurance companies, money market funds, etc., and Paulson thought without a bailout the economy would come screeching to a halt. Ordinary folks would lose all confidence and rush to withdraw their money (some of this has already happened, as you point out), and nobody would have any money to lend. Without available credit, businesses couldn’t pay their employees and the whole house would come crashing down. I guess the real question I still donm’t get is how did we get all these bad mortgages in the first place, and how did they spread so far and so fast? Any thoughts on that, madam guru?

gopsu: What happened was the government created Fannie and Freddie basically to create more bad mortgages. Their ideal was noble – providing more affordable housing – but what that translated into was telling banks to lower their standards in giving loans and mortgages to people who couldn’t afford more expensive housing. Just because they could now get a loan didn’t mean they’d ever be able to pay it back – which they couldn’t. So more and more people bought houses they couldn’t afford, or bigger and better new houses they couldn’t afford, and others just bought up property because the real estate market was so good. Everyone tried to take advantage of this, and the banks were cushioned from these bad loans because they sold the mortgages to Fannie and Freddie, so they kept giving out more. And..well, you know the rest of the story by now.

Goosie: ha, well, I hope you’d read my blog anyway. 🙂 I didn’t like the bailout plan either, and was kind of mad that people – ok, McCain especially – didn’t talk much about the Republican’s “other option” which would still help bailout the economy but would *lend* money to the businesses for their bad assets, and make them pay for their own trouble and poor judgement, instead of just wiping the slate clean. Hopefully, some version of that is what will pass.